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September 20, 2013

BD Stocks: What to Expect as QE Rolls On

Citi analysts say some broker-dealers could weaken in the short term thanks to the Fed's latest move, while some asset managers may strengthen

Following the Fed’s decision on Wednesday to continue its quantitative easing program, Citigroup equity analysts (C) are predicting that some broker-dealers and asset managers could see their results and stocks hurt over the next few months.

“First, we expect broker-dealers to lag and/or consolidate in the short term, given embedded rate leverage and recent outperformance,” wrote William Katz in a note released Thursday, co-written with Neil Stratton and Steve Fullerton.

“The key question [for BDs] is whether the pushback of tapering is temporary in nature or reflective of a more sustained delay, which would materially impact timing to reach normalized earnings.”

The equity analysts' second concern is that equity-centric asset managers may lag more fixed-income-focused managers. “Stepping back, we wonder if the delay in tapering calls into question: (a) the strength of the economic recovery, and (b) timing/rapidity of short-term rates hikes,” Katz wrote.

Short vs. Long Term

Citigroup’s equity research team says that it hasn’t changed its positive long-term view of broker-dealer stocks, due to “bottoming EPS expectations, improving retail re-engagement and higher net interest margins.”

Near term, though, Katz and his colleagues see LPL Financial (LPLA) and Raymond James (RJF) as being in a defensive position given the fixed-income focus of some of their businesses and their “lower correlation to the long end of the curve” relative to TD Ameritrade (AMTD) and Charles Schwab (SCHW).

Still, he expects the stock prices of these two online brokers to lag, too, in the short term, “given their recent outperformance.”

Meanwhile, the iShares Dow Jones U.S. Broker-Dealer Index (IAI) is up about 22%. It’s being outpaced by some components like Morgan Stanley (MS), which has jumped 40% in the past five months.

Citi says that, year to date, the correlation between Schwab and TD Ameritrade with the 10-year Treasury is high, at roughly +0.90, and is negative for Raymond James.

Other Firms

Looking at traditional asset managers, Citi is looking more favorably at those with a fixed-income focus. It believes fixed-income centric managers could outperform “as net-asset-value risks diminish while fixed-income volumes become more sustainable in the short term.

Alliance Bernstein (AB), Legg Mason (LM), Franklin Templeton (BEN) and BlackRock (BLK) have the largest fixed-income exposure of between 36% and 59% of assets.

Also, says Katz, the stocks of these firms, with the exception of Legg Mason, have lagged the group since May 1, "setting up for a possible catch-up trade.”

This group benefits in the short term, “as less-aggressive rate expectations reduce pressure on financing costs,” Katz says.

Still, the prospect of reduced economic growth means that rising credit spreads and the earnings before taxes of these firm’s underlying portfolios need to be closely watched. Historically, alternatives underperform when spreads rise, the analyst points out.